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We analysed data stretching back to 1975, looking at the trade-weighted dollar before and after the Federal Reserve (Fed) starts the process of raising rates.

As shown in Chart 1, the performance of the dollar in the current interest rate cycle has been very different to the past.

This time, the US dollar rose close to 20% in the 24 months leading up to the first rate hike. Historically, however, the dollar has depreciated steadily in the run up.

Post the rate hike, performance is more mixed. On average, the trade-weighted dollar weakens by around 1.6% 12 months after, with four out of the eight cycles examined seeing negative trade-weighted dollar performance.

Meanwhile, 24 months after the hike, the average performance of the trade-weighted dollar across cycles has historically been positive, although this result is skewed by the 1980s cycle, in which the dollar was particularly strong.

How will the dollar perform in this cycle?

With rates in the US expected to rise versus a host of other major central banks that are keeping rates stuck at zero, one argument states that increasing uptake in the gradually more attractive long US dollar carry trade should mean the dollar will continue to perform strongly.

To test this, we looked at the relationship between the US/Germany interest rate differential and the performance of the dollar/euro exchange rate in past cycles. As a proxy for interest rates, we used US and German 3-month bills.

The spread between the two is rebased in absolute terms to equal zero when the Fed first hikes. Therefore, when the spread is positive, US rates are higher than German rates compared to when the first hike in the cycle took place.

On the whole, the impact of interest rate differentials on dollar movements in past cycles looks to be stronger before the first rate hike than after it.

This is particularly the case in the 1994 and 1999 hiking cycles, where initially rates and currencies moved together before
a pronounced divergence occurred when the Fed finally hiked.

This suggests that other factors apart from purely carry may be at work. These include changing expectations of future interest rate differentials and capital flows on the expectation of foreign asset performance.

History therefore suggests that the dollar is perhaps not set for a path of continued strength, even if interest rates between the US and Europe diverge further.